Yet this is a market that remains comparatively unknown for a
number of reasons, not the least of which is the fact that the rules
surrounding it are very complex. Unlike other commodities, to
successfully invest directly in carbon assets one must have a complete
understanding of various layers of rules and regulations, starting at
the top with broad public policy objectives all the way down to the
minutiae of how carbon assets can be traded.

These two products, launched in the past year, provide
investors with direct exposure to carbon contracts. In a way, they
are a much more direct means of expressing one's view on the carbon
market than going through the back door by owning an exchange such as
Climate Exchange PLC (CXCHY.PK) or a trading platform like World Energy (XWES).

Although I first discussed GRN and ASO in early January,
I never researched either of them in any detail. Yesterday, I looked
into how they had been performing in 2009. The graph below shows
their performance over the past six months.

What accounts for GRN's seeming outperformance (I haven't checked for
statistical significance) is the composition of the underlying
portfolio of carbon assets. The following table provides a summary of
the main carbon assets traded around the world (for a larger table, you
can download the Barclays Capital report from which I took it and scroll to page 4).

Currently, the most liquid and active carbon markets are for the EU
ETS' EUAs and secondary CERs (see table above). I will not cover the
rules of the EU ETS in this article, but you can find a detailed
overview of the program here. In 2008, out of a total of about
$126 billion transacted on international carbon markets, EUAs accounted
for $92 billion and secondary CERs $26 billion - together, they made up
roughly 94% of transacted value.

EUAs must be surrendered to governments by regulated companies each
year in an amount equivalent to the company's emissions. CERs can also
be used toward meeting regulatory requirements, although their use is
capped at 13.5% of total permit requirements in the EU ETS
(this varies by country). CERs thus tend to trade at a discount to EUAs
even though the marginal cost of abatement might be lower in the emerging economies where they are generated.

GRN Vs. ASO

Although they both hold carbon futures contracts transacted on the European Climate Exchange, GRN and ASO are set-up very differently.

ASO, according to information available on its website, holds a basket of EUA futures
of different vintages - that is, of different compliance years - that
is rolled over annually. You can view the current portfolio here.
ASO holds the futures until shortly before the EUAs come due
in December of each year, at which time it sells them and uses the
proceeds to invest "in futures contracts expiring in December of the
next five subsequent years [...]" Since ASO is not a regulated entity
under the EU ETS, there is no sense in the fund taking physical
delivery of the EUAs.

GRN, on the other hand, holds a basket of EUA (~79%) and CER (~21%) futures.
The weights are determined annually by a committee and the index is
re-weighted in November of each year. The other major - and, arguably,
more important - difference with ASO is the fact that GRN holds only
current year contracts. When it is re-weighted each November, the futures
for period T (current year) are thus entirely replaced
with futures for period T+1.

Because ASO looks five years
out, a strong agreement in Copenhagen in December would be
favorable for the fund, as the EU has indicated that it would raise its
greenhouse gas reduction target from 20% below 1990 level by 2020 to
30% below 1990 by 2020 if such an agreement were reached. The 2013
futures then held by ASO following the annual roll would most likely
experience a pop.

Additionally, if the US were to join the carbon trading club by the end
of the year, the long-term picture would brighten substantially, which
again might favor ASO.

Besides these macro events, I don't currently have a view on which
security is superior as I haven't done sufficient analysis of the EU
ETS yet. This is something I intend to do in the next few weeks and
months, as I think interest in this commodity will grow substantially in the lead-up to Copenhagen.

DISCLOSURE: None

UPDATE (JULY 28, 2009): A reader alerted me to this: http://www.indexuniverse.com/sections/newsinfocus/6256-xshares-to-close-carbon-etf-.html - ASO has now been withdrawn. Not especially surprising in my opinion.